Letters, Presentations, and More!

A long-simmering synaptic overflow.

Hello and Happy almost-Thanksgiving to my fellow American readers out there. It’s been a while since I published a post, though I’ve drafted and then deleted several this year. Nearly all my discourse with fellow investors happens over on Twitter these days, but with that platform headed in a bad direction, you’ll likely find me on Substack more often. I’m not interested in competing for readership with crypto spammers and ethno-nationalists, and each group seems to be enjoying a renaissance on the Bird App.

In lieu of a traditional quick analysis of some interesting security or trend, I thought I would present several news items that have caught my eye as well as some recent Alluvial projects.

Q3 Letter! For anyone who hasn’t seen it, here’s Alluvial’s Q3 letter. I’ll be the first to admit I am not having fun this year. The market and I are fundamentally at odds on many of our holdings. I’m proud that Alluvial has managed to out-perform indexes, both this year and since inception, but 2022 has been a slog from the beginning. The market mood seems less gloomy than earlier this year, but this cheerier outlook hasn’t yet flowed down to the small and off-the-run securities where I spend most of my time. Many securities remain at or near their 2022 lows. All the same, these doldrums are producing the healthiest crop of special situations, deep value opportunities, and attractively-priced high quality businesses in quite some times. For anyone willing to look ahead 1-3 years, I think there is plenty to buy today.

We.Connect SA analysis! We pulled together a presentation on one of my favorite small companies. We.Connect is a French IT distributor with a focus on consumer technologies. Despite an extraordinary track record, We.Connect remains almost completely unknown and deeply under-valued, trading at a mid-single digit multiple of earnings. Please enjoy the analysis but mind the disclaimers: We.Connect is a tiny company with highly illiquid shares. It’s not at all appropriate for short-term investment and I’m not recommending anyone go out and buy shares.

Subsidies on Subsidies. Rural telecoms have been major beneficiaries of federal and state subsidies designed to increase access to broadband internet for rural households and businesses. My favorite, LICT Corporation, receives over $30 million in annual support designed to subsidize the build-out of modern fiber infrastructure in its service territories. And now, here comes another giant wave of grants! Thanks to the Department of Agriculture’s ReConnect program, LICT will receive another $128 million. That’s $7,300 per share and 35% of LICT’s market capitalization. I don’t expect a material short-term uplift in revenues or profits from the resulting fiber expansion, given the sparsely-populated areas targeted by the program. But I do like that LICT will be the sole provider of fiber-based broadband internet in these areas, now and in all likelihood, forever. The market seems completely unaware of the upcoming windfall.

Selling When the Selling is Good. I have a lot of respect for management teams that can look around and say “Wow, our assets sure are in demand right now. Can you believe these prices? Let’s sell.” It’s pretty rare. But two different OTC-traded real estate companies have come to the same conclusion this year: Tower Properties and Maxus Realty Trust. Both have long-tenured management teams that have seen cycles come and go, and each is taking advantage of the red-hot market for multi-family properties. Earlier this month, Tower Properties completed the sale of a 208 unit apartment complex in Kansas, realizing net cash proceeds of 20% of the company’s market capitalization. Often Tower will sell a property and then use a 1031 exchange to buy another property, deferring taxes, but this time management doesn’t seem to see anything worth buying. I suspect a large special dividend is on the way. Maxus is taking things a step further, looking to sell up to all of its substantial multi-family holdings. Thus far Maxus has sold 11 properties and is under contract to sell another 11. At this pace, Maxus will have sold its entire multi-family portfolio by early next year. Maxus has realized selling prices of 15x gross rents on average, or cap rates of 4% assuming net operating income of 60% of gross rents. To me, these valuations appear wildly high, but what do I know? I am a lifelong resident of the Rust Belt. If Maxus can sell its remaining properties at similar valuations, shareholders ought to be sending lovely holiday gifts to company HQ.

The Question of Over-Earning. Looking at the broad investment landscape, it’s apparent that companies in many industries are over-earning. In the post-COVID environment of high inflation and lingering supply chain issues, producers of commodities and basic materials have experienced an earnings bonanza. Question is, how long will it last, and what should we be willing to pay for businesses whose earnings will almost certainly decrease to normal or sub-normal at some point in medium term? Despite what some super bulls may say, commodities prices always revert to the mean at some point. The cure for high prices is high prices. Persistently high commodities prices result in commodities producers earning excess profits, which always attracts a wave of investment and new supply, which inevitably results in prices collapsing, often to below-trend levels. And then the process repeats in reverse. Tale as old as time.

A classic “value investor” mistake (of which I am not innocent) is to buy a cyclical company at a cheap multiple of trailing net income or cash flows, say 6-7x, not realizing the company’s profitability has peaked and is about to plunge. That highly attractive P/E multiple is actually a not so lovely 18-20x mid-cycle earnings. OK, so the lesson is “Don’t pay mid/high single digits multiples of trailing net income for cyclicals at peak earnings.” Easier said than done, but a valid principle. But what about cases where we know a company is over-earning, but shares can be bought for 1-2x trailing results and 6-7x mid-cycle profits? Especially if a few more quarters of super-profitability will bring enterprise value down another 20-30%? In these cases, I think there is a case for owning shares despite the certainty of decreasing profits.

A good example is Arctic Paper SA. Arctic is a Polish/Swedish producer of paper and wood pulp. Arctic is a fairly good paper company, but still a paper company and subject to the cyclicality of paper and pulp pricing. From 2015-2019, the company averaged zł 230 million in annual EBITDA and an EBITDA margin of 7-8%. Then came 2021. Paper and pulp prices exploded and suddenly Arctic Paper is producing EBITDA of zł 900 million in EBITDA at a 19% margin. The company has used this windfall to flip from a position of moderate leverage to a strong net cash position. Now, Arctic Paper is trading at just 2.3x trailing EBITDA (accounting for minority interest) and 3x trailing net income (just 2x annualized Q3 results.) With wood pulp prices setting new highs, it is likely Arctic Paper will record incredible profits for at least the next few quarters before declining. Let’s say the party continues for another year. Maybe that’s aggressive, maybe not. But if it does, that would take Arctic Paper’s enterprise value down by half and leave it trading at around 3.3x normalized EBITDA, which the company pegs at zł 300 million with its current facilities. Is that cheap enough? I don’t have a complete answer yet. It probably depends on the company’s skill with capital allocation. Will it use its windfall profits to return capital to shareholders and fund high return internal projects, or will it fund a variety of marginal projects just because it suddenly can?

This is just one example, but similar dynamics are playing out in natural gas, coal, base metals, and all manner of other commodity and base materials producing businesses. My point is: investing in a cyclical company at 6+ times peak earnings is a bad idea. But at 3x? 2x? At some valuation shares are attractive, even if future earnings will certainly trend downward. In my view, the market is discounting many of these temporary over-earners too sharply.